CHAPTER THTREE

FIXED INCOME SECURITIES

4.1 Introductions
Fixed-income securities are exactly what the name suggests: securities that promise to
make fixed payments according to some preset schedule. The other key characteristic of a
fixed-income security is that, like a money market instrument, it begins life as a loan of
some sort. Fixed-income securities are therefore debt obligations. They are typically issued
by corporations and governments. Unlike money market instruments, fixed-income
securities have lives that exceed 12 months at the time they are issued.(marg. def. fixed-
income securities Longer-term debt obligations, often of corporations and governments,
that promise to make fixed payments according to a preset schedule.)
The words "note" and "bond" are generic terms for fixed-income securities, but "fixed
income" is really more accurate. This term is being used more frequently as securities are
increasingly being created that don't fit within traditional note or bond frameworks, but
are nonetheless fixed income securities.
SOME EXAMPLES OF FIXED-INCOME SECURITIES, to give one particularly simple example
of a fixed income security, near the end of every month, the most governments sells
between $10 billion and $20 billion of two-year notes to the public. If you buy a two-year
note when it is issued, you will receive a check every six months for two years for a fixed
amount, called the bond's coupon, and in two years you will receive the face amount on the
note.
Suppose you buy $1 million in face amount of a 6 percent, two-year note. The 6 percent is
called the coupon rate, and it tells you that you will receive 6 percent of the $1 million face
value each year, or $60,000, in two $30,000 semiannual "coupon" payments. In two years,
in addition to your final $30,000 coupon payment, you will receive the $1 million face
value. The price you would pay for this note depends on market conditions. Example 4.1: A
Note-Worthy Investment? Suppose you buy $100,000 in face amount of a just-issued five-
year U.S. Treasury note. If the coupon rate is 5 percent, what will you receive over the next
five years if you hold on to your investment?
You will receive 5 percent of $100,000, or $5,000, per year, paid in two semiannual
coupons of $2,500. In five years, in addition to the final $2,500 coupon payment, you will
receive the $100,000 face amount.
To give a slightly different example, suppose you take out a 48-month car loan. Under the
terms of the loan, you promise to make 48 payments of $400 per month. It may not look
like it to you, but in taking out this loan, you have issued a fixed-income security to your
bank. In fact, your bank may turn around and sell your car loan (perhaps bundled with a
large number of others) to an investor. Actually, car loans are not sold all that often, but
there is a very active market in student loans, and student loans are routinely bought and
sold in huge quantities.
FIXED-INCOME PRICE QUOTES Prices for fixed-income securities are quoted in different
ways, depending on, among other things, what type of security is being priced. As with

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money market instruments, there are various details that are very important (and often
overlooked).
The potential gains from owning a fixed-income security come in two forms. First, there are
the fixed payments promised and the final payment at maturity. In addition, the prices of
most fixed income securities rise when interest rates fall, so there is the possibility of a gain
from a favorable movement in rates. An unfavorable change in interest rates will produce a
loss.

Another significant risk for many fixed-income securities is the possibility that the issuer
will not make the promised payments. This risk depends on the issuer. It doesn't exist for
government bonds, but for many other issuers the possibility is very real. Finally, unlike
most money market instruments, fixed-income securities are often quite illiquid, again
depending on the issuer and the specific type.

4.2 Bond Characteristics

A bond is basically a loan issued by a corporation or government entity. The issuer pays the
bondholder a specified amount of interest for a specified time, usually several years, and
then repays the bondholder the face amount of the bond.

A bond can be characterized based on (1) its intrinsic features, (2) its type, (3) its indenture
provisions, or (4) the features that affect its cash flows and/or its maturity.

Intrinsic Features; The coupon, maturity, principal value, and the type of ownership are
important intrinsic features of a bond. The coupon of a bond indicates the income that the
bond investor will receive over the life (or holding period) of the issue. This is known as
interest income, coupon income, or nominal yield. Sometimes, however, zero-coupon bonds
are issued that make no coupon payments. In this case, investors receive par value at the
maturity date, but receive no interest payments until then: The bond has a coupon rate of
zero. These bonds are issued at prices considerably below par value, and the investor’s
return comes solely from the difference between issue price and the payment of par value
at maturity. We will return to these bonds below.

The term to maturity specifies the date or the number of years before a bond matures (or
expires). There are two different types of maturity. The most common is a term bond,
which has a single maturity date. Alternatively, a serial obligation bond issue has a series
of maturity dates, perhaps 20 or 25. Each maturity, although a subset of the total issue, is
really a small bond issue with generally a different coupon. Municipalities issue most serial
bonds.

The principal, or par value, of an issue represents the original value of the obligation. This
is generally stated in $1,000 increments from $1,000 to $25,000 or more. Principal value is

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not the same as the bond’s market value. The market prices of many issues rise above or
fall below their principal values because of differences between their coupons and the
prevailing market rate of interest. If the market interest rate is above the coupon rate, the
bond will sell at a discount to par. If the market rate is below the bond’s coupon, it will sell
at a premium above par. If the coupon is comparable to the prevailing market interest rate,
the market value of the bond will be close to its original principal value. Finally, bonds
differ in terms of ownership. With a bearer bond, the holder, or bearer, is the owner, so
the issuer keeps no record of ownership. Interest from a bearer bond is obtained by
clipping coupons attached to the bonds and sending them to the issuer for payment. In
contrast, the issuers of registered bonds maintain records of owners and pay the interest
directly to them.

Types of Issues: In contrast to common stock, companies can have many different bond
issues outstanding at the same time. Bonds can have different types of collateral and be
senior, unsecured, or subordinated (junior) securities. Secured (senior) bonds are backed
by a legal claim on some specified property of the issuer in the case of default. For example,
mortgage bonds are secured by real estate assets; equipment trust certificates, which are
used by railroads and airlines, provide a senior claim on the firm’s equipment. Unsecured
bonds (debentures) are backed only by the promise of the issuer to pay interest and
principal on a timely basis. As such, they are secured by the general credit of the issuer.
Subordinate (junior) debentures possess a claim on income and assets that is
subordinated to other debentures. Income issues are the most junior type because interest
on them is paid only if it is earned. Although income bonds are unusual in the corporate
sector, they are very popular municipal issues, where they are referred to as revenue
bonds. Finally, refunding issues provide funds to prematurely retire another issue.

The type of issue has only a marginal effect on comparative yield because it is the
credibility of the issuer that determines bond quality. A study of corporate bond price
behavior found that whether the issuer pledged collateral did not become important until
the bond issue approached default. The collateral and security characteristics of a bond
influence yield differentials only when these factors affect the bond’s quality ratings.

Indenture Provisions: The indenture is the contract between the issuer and the
bondholder specifying the issuer’s legal requirements. A trustee (usually a bank) acting on
behalf of the bondholders ensures that all the indenture provisions are met, including the
timely payment of interest and principal. All the factors that dictate a bond’s features, its
type, and its maturity are set forth in the indenture.

Features Affecting Bond’s Maturity:- Investors should be aware of the three alternative
call option features that can affect the life (maturity) of a bond. One extreme is a freely
callable provision that allows the issuer to retire the bond at any time with a typical

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notification period of 30 to 60 days. The other extreme is a non-callable provision wherein
the issuer cannot retire the bond prior to its maturity. Intermediate between these is a
deferred call provision, which means the issue cannot be called for a certain period of time
after the date of issue (e.g., 5 to10 years). At the end of the deferred call period, the issue
becomes freely callable. Callable bonds have a call premium, which is the amount above
maturity value that the issuer must pay to the bondholder for prematurely retiring the
bond. A non-refunding provision prohibits a call and premature retirement of an issue from
the proceeds of a lower-coupon refunding bond. This is meant to protect the bondholder
from a typical refunding, but it is not fool proof. An issue with a non-refunding provision
can be called and retired prior to maturity using other sources of funds, such as excess cash
from operations, the sale of assets, or proceeds from a sale of common stock.

Another important indenture provision that can affect a bond’s maturity is the sinking
fund, which specifies that a bond must be paid off systematically over its life rather than
only at maturity. There are numerous sinking-fund arrangements, and the bondholder
should recognize this as a feature that can change the stated maturity of a bond. The size of
the sinking fund can be a percentage of a given issue or a percentage of the total debt
outstanding, or it can be a fixed or variable sum stated on a dollar or percentage basis.
Similar to a call feature, sinking fund payments may commence at the end of the first year
or may be deferred for 5 or 10 years from date of the issue. The amount of the issue that
must be repaid before maturity from a sinking fund can range from a nominal sum to 100
percent. Like a call, the sinking-fund feature typically carries a nominal premium but is
generally smaller than the straight call premium (e.g., 1 percent). For example, a bond issue
with a 20-year maturity might have a sinking fund that requires that5 percent of the issue
be retired every year beginning in year 10. By year 20, half of the issue has been retired
and the rest is paid off at maturity. Sinking-fund provisions have a small effect on
comparative yields at the time of issue but have little subsequent impact on price behavior.
A sinking-fund provision is an obligation and must be carried out regardless of market
conditions. Although a sinking fund allows the issuer to call bonds on a random basis, most
bonds are retired for sinking-fund purposes through direct negotiations with institutional
holders. Essentially, the trustee negotiates with an institution to buy back the necessary
amount of bonds at a price slightly above the current market price.

4.3 Bond Price

Because a bond’s coupon and principal repayments all occur months or years in the future,
the price an investor would be willing to pay for a claim to those payments depends on the
value of dollars to be received in the future compared to dollars in hand today. This
“present value” calculation depends in turn on market interest rates. The nominal risk-free
interest rate equals the sum of (1) a real risk-free rate of return and (2) a premium above

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the real rate to compensate for expected inflation. In addition, because most bonds are not
riskless, the discount rate will embody an additional premium that reflects bond-specific
characteristics such as default risk, liquidity, tax attributes, call risk, and so on.

We simplify for now by assuming there is one interest rate that is appropriate for
discounting cash flows of any maturity, but we can relax this assumption easily. In practice,
there may be different discount rates for cash flows accruing in different periods. For the
time being, however, we ignore this refinement.

To value a security, we discount its expected cash flows by the appropriate discount rate.
The cash flows from a bond consist of coupon payments until the maturity date plus the
final payment of par value. Therefore

Bond value = Present value of coupons + Present value of par value

If we call the maturity date T and call the discount rate r, the bond value can be written as

Where t/T= the number of periods before the bond matures

r= interest rate

The summation sign in Equation directs us to add the present value of each coupon
payment; each coupon is discounted based on the time until it will be paid. The first term
on the right-hand side of Equation is the present value of an annuity. The second term is
the present value of a single amount, the final payment of the bond’s par value.

You may recall from an introductory finance class that the present value of a $1 annuity
that lasts for T periods when the interest rate equals r is

We call this expression the T -period annuity factor for an interest rate of r. Similarly, we
call PV factor, i.e., the present value of a single payment of $1 to be received in T periods.
Therefore, we can write the price of the bond as

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Example, XYZ Company issues 8% coupon, 30-year maturity bond with par value of Birr
1,000 paying semiannual coupon payments. Suppose that the interest rate is 8% annually,
and ABC Company wants to purchase this asset, by how much birr should ABC purchase
the financial assets?

Solution:

Given r= 8%, semiannually 8%/2 =4%

T= 30 year, the coupon paid twice in year, 30*2 = 60

Coupon= 1000*0.04= 40

Principal = 1000
60
40 1000
∑ (1.04)❑60
+
(1.04)❑60
t =1

40 * annuity factor (4%, 60) + 1,000 * PV factor (4%, 60)

It is easy to confirm that the present value of the bond’s 60 semiannual coupon payments
of $40 each is $904.94, and that the $1,000 final payment of par value has a present value
of$95.06, for a total bond value of $1,000. So ABC could purchase the financial asset at its
face value.

In this example, the coupon rate equals the market interest rate, and the bond price equals
par value. If the interest rate were not equal to the bond’s coupon rate, the bond would not
sell at par value. For example, if the interest rate were to rise to 10% (5% per six months),
the bond’s price would fall by 189.29, to 810.71, as follows

40 * Annuity factor (5%, 60) + 1,000 * PV factor (5%, 60)

= $757.17 + $53.54 = $810.71

At a higher interest rate, the present value of the payments to be received by the
bondholder is lower. Therefore, the bond price will fall as market interest rates rise. This
illustrates a crucial general rule in bond valuation. When interest rates rise, bond prices
must fall because the present value of the bond’s payments is obtained by discounting at a

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higher interest rate. The effect of interest rate changes on bond prices will vary from bond
to bond and will depend upon a number of characteristics of the bond.

(a) The maturity of the bond- Holding coupon rates and default risk constant,
increasing the maturity of a straight bond will increase its sensitivity to interest rate
changes. The present value of cash flows changes much more for cash flows further
in the future, as interest rates change, than for cash flows which are nearer in time.
(b) The coupon rate of the bond- Holding maturity and default risk constant,
increasing the coupon rate of a straight bond will decrease its sensitivity to interest
rate changes. Since higher coupons result in more cash flows earlier in the bond's
life, the present value will change less as interest rates change. At the extreme, if the
bond is a 'zero-coupon' bond, the only cash flow is the face value at maturity, and
the present value is likely to vary much more as a function of interest rates.

A bond may be selling at par value when its coupon rate equals the market interest rate. In
these circumstances, the investor receives fair compensation for the time value of money in
the form of the recurring coupon payments. No further capital gain is necessary to provide
fair compensation. When the coupon rate is lower than the market interest rate, the coupon
payments alone will not provide investors as high a return as they could earn elsewhere in
the market. To receive a fair return on such an investment, investors also need to earn
price appreciation on their bonds. The bonds, therefore, would have to sell below par value
to provide a “built-in” capital gain on the investment.

To illustrate build-in capital gains or losses, suppose a bond was issued several years ago
when the interest rate was 7%. The bond’s annual coupon rate was thus set at 7%. (We will
suppose for simplicity that the bond pays its coupon annually.) Now, with three years left
in the bond’s life, the interest rate is 8% per year. The bond’s fair market price is the
present value of the remaining annual coupons plus payment of par value. That present
value is:

$70 *Annuity factor (8%, 3) + $1,000 * PV factor (8%, 3) = $974.23

-Which is less than par value.

In another year, after the next coupon is paid, the bond would sell at

$70 * Annuity factor (8%, 2) + $1,000 * PV factor (8%, 2) = $982.17

Thereby yielding a capital gain over the year of $7.94, if an investor had purchased the
bond at $974.23, the total return over the year would equal the coupon payment plus
capital gain, or $70 + $7.94 = $77.94. This represents a rate of return of $77.94/$974.23, or
8%, exactly the current rate of return available elsewhere in the market current rate of

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return available elsewhere in the market. When bond prices are set according to the
present value formula, any discount from par value provides an anticipated capital gain
that will augment a below-market coupon rate just sufficiently to provide a fair total rate of
return. Conversely, if the coupon rate exceeds the market interest rate, the interest income
by itself is greater than that available elsewhere in the market. Investors will bid up the
price of these bonds above their par values. As the bonds approach maturity, they will fall
in value because fewer of these above-market coupon payments remain. The resulting
capital losses offset the large coupon payments so that the bondholder again receives only
a fair rate of return.

4.4Bond Yields
We have noted that the current yield of a bond measures only the cash income provided by
the bond as a percentage of bond prices and ignores any prospective capital gains or losses.
We would like a measure of rate of return that accounts for both current incomes as well as
the price increase or decrease over the bond’s life. The yield to maturity is the standard
measure of the total rate of return. However, it is far from perfect, and we will explore
several variations of this measure. Nominal yield is the coupon rate of a particular issue. A
bond with an 8% coupon has an 8% nominal yield. It therefore provides a convenient way
of describing the coupon characteristics of the bond.

Yield to Maturity
In practice, an investor considering the purchase of a bond is not quoted a promised rate of
return. Instead, the investor must use the bond price, maturity date, and coupon payments
to infer the return offered by the bond over its life. The yield to maturity (YTM) is defined
as the discount rate that makes the present value of a bond’s payments equal to its price.
This rate is often viewed as a measure of the average rate of return that will be earned on a
bond if it is bought now and held until maturity. For example, suppose an 8% coupon, $
1000 par value, 30-year bond is selling at $1,276.76. What average rate of return would be
earned by an investor purchasing the bond at this price? We find the interest rate at which
the present value of the remaining 60 semiannual payments equals the bond price. This is
the rate consistent with the observed price of the bond. Therefore, we solve for r in the
following equation

Or, equivalently,

1, 276.76 = 40 * Annuity factor(r, 60) + 1,000 * PV factor(r, 60)

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These equations have only one unknown variable, the interest rate, r. You can use a
financial calculator or spreadsheet to confirm that the solution is r = .03, or 3% per half-
year. This is considered the bond’s yield to maturity.

Yields annualized using simple interest is also called bond equivalent yields. Therefore, the
semiannual yield would be doubled and reported in the newspaper as a bond equivalent
yield of 6%. The effective annual yield of the bond, however, accounts for compound
interest. If one earns 3% interest every six months, then after one year, each dollar
invested grows with interest to $1 * (1.03)2 = 1.0609, and the effective annual interest rate
on the bond is 6.09%.The bond’s yield to maturity is the internal rate of return on an
investment in the bond. The yield to maturity can be interpreted as the compound rate of
return over the life of the bond under the assumption that all bond coupons can be
reinvested at that yield. Yield to maturity therefore is widely accepted as a proxy for
average return.

Yield to maturity differs from the current yield of a bond, which is the bond’s annual
coupon payment divided by the bond price. For example, for the 8%, 30-year bond
currently selling at $1,276.76, the current yield would be $80/$1,276.76 = 0.0627, or
6.27% per year. In contrast, recall that the effective annual yield to maturity is 6.09%. For
this bond, which is selling at a premium over par value ($1,276 rather than $1,000), the
coupon rate (8%) exceeds the current yield (6.27%), which exceeds the yield to maturity
(6.09%).The coupon rate exceeds current yield because the coupon rate divides the coupon
payments by par value($1,000) rather than by the bond price ($1,276).In turn, the current
yield exceeds yield to maturity because the yield to maturity accounts for the built-in
capital loss on the bond; the bond bought today for $1,276 will eventually fall in value to
$1,000 at maturity. This example illustrates a general rule: For premium bonds (bonds
selling above par value), coupon rate is greater than current yield, which in turn is greater
than yield to maturity. For discount bonds (bonds selling below par value), these
relationships are reversed.

Yield to Call
Callable bonds, some corporate bonds are issued with call provisions, allowing the issuer
to repurchase the bond at a specified call price before the maturity date. For example, if a
company issues a bond with a high coupon rate when market interest rates are high, and

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interest rates later fall, the firm might like to retire the high-coupon debt and issue new
bonds at a lower coupon rate to reduce interest payments. The proceeds from the new
bond issue are used to pay for the repurchase of the existing higher coupon bonds at the
call price. This is called refunding. Callable bonds typically come with a period of call
protection, an initial time during which the bonds are not callable. Such bonds are referred
to as deferred callable bonds. Puttable bonds while the callable bond gives the issuer the
option to extend or retire the bond at the call date, the extendable or put bond gives this
option to the bondholder. If the bond’s coupon rate exceeds current market yields, for
instance, the bondholder will choose to extend the bond’s life. If the bond’s coupon rate is
too low, it will be optimal not to extend; the bondholder instead reclaims principal, which
can be invested at current yields. Floating-rate bonds Floating-rate bonds make interest
payments that are tied to some measure of current market rates. For example, the rate
might be adjusted annually to the current T-bill rate plus 2%. If the one-year T-bill rate at
the adjustment date is 4%, the bond’s coupon rate over the next year would then be 6%.
This arrangement means that the bond always pays approximately current market rates.

Yield to maturity is calculated on the assumption that the bond will be held until maturity.
What if the bond is callable, however, and may be retired prior to the maturity date? How
should we measure average rate of return for bonds subject to a call provision?

At high market interest rates, the risk of call is negligible because the present value of
scheduled payments is less than the call price; therefore, the values of the straight and
callable bonds converge. At lower rates, however, the values of the bonds begin to diverge,
with the difference reflecting the value of the firm’s option to reclaim the callable bond at
the call price. At very low market rates the present value of schedule payments significantly
exceeds the call price, so the bond is called.

This analysis suggests that bond market analysts might be more interested in a bond’s yield
to call rather than its yield to maturity, especially if the bond is likely to be called. The yield
to call is calculated just like the yield to maturity, except that the time until call replaces
time until maturity and the call price replaces the par value. This computation is sometimes
called “yield to first call,” as it assumes the issuer will call the bond as soon as it may do so.

Example: Suppose the $1000 par value, 8% coupon semiannually, 30-year maturity bond
sells for $1,150 and is callable in 10 years at a call price of $1,100. Its yield to maturity and
yield to call would be calculated using the following inputs:

Yield to Call Yield to Maturity

Coupon payment $40 $40

Number of semiannual periods 20 periods 60 periods

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Final payment $1,100 $1,000

Price $1,150 $1,150

40
40 1100
1150=∑ +
t=1 (1+r ) , (1+r )20 ,
t

Yield to call is then 6.64%. In contrast, yield to maturity is 6.82%.Notice that redemption
value is 110, i.e., 110% of par value.

We have noted that most callable bonds are issued with an initial period of call protection.
In addition, an implicit form of call protection operates for bonds selling at deep discounts
from their call prices. Even if interest rates fall a bit, deep-discount bonds still will sell
below the call price and thus will not be subject to a call. Premium bonds that might be
selling near their call prices, however, are especially apt to be called if rates fall further. If
interest rates fall, a callable premium bond is likely to provide a lower return than could be
earned on a discount bond whose potential price appreciation is not limited by the
likelihood of a call. Investors in premium bonds often are more interested in the bond’s
yield to call rather than yield to maturity as a consequence, because it may appear to them
that the bond will be retired at the call date.

Horizon Yield
This measures the expected rate of return of a bond that you expect to sell prior to its
maturity. It is therefore a total return measure which, allows the portfolio manager to
project the performance of a bond on the basis of a planned investment horizon, his
expectations concerning reinvestment rates and future market yields. This allows the
portfolio manager to evaluate which of several potential bonds considered for investment
will perform best over the planned investment horizon.

Using total return to assess performance over some investment horizon is called Horizon
Analysis while the return calculated over the horizon is called Horizon Yield or Return.

The disadvantage of this approach for calculating return is that it requires the portfolio
manager to make some assumptions about reinvestment rates, future yields and to think in
terms of a specified period or horizon. It however enables the manager to evaluate the
performance of a bond under different interest rate scenarios thereby assessing the
sensitivity of the bond to interest rate changes.

Suppose you buy a 30-year, 7.5% (annual payment) coupon bond for $980 (when its yield
to maturity is 7.67%) and plan to hold it for 20 years. Your forecast is that the bond’s yield
to maturity will be 8% when it is sold and that the reinvestment rate on the coupons will be

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6%. At the end of your investment horizon, the bond will have 10 years remaining until
expiration, so the forecast sales price (using a yield to maturity of 8%) will be $966.45. The
20 coupon payments will grow with compound interest to $2,758.92. (This is the future
value of a 20-year $75 annuity with an interest rate of 6%.)

Based on these forecasts, your $980 investment will grow in 20 years to $966.45 +
$2,758.92 = $3,725.37. This corresponds to an annualized compound return of 6.90%:

$980(1+r) 20 = $3,725.37

r= 0.0690 = 6.90%

4.4 Risks in bond

Credit risk

Credit risk occurs when the issuer default on the payment of the coupon, and even the
principal amount. This may occur if the issuer has problems meeting its obligations as
promised. This is also known as default risk or issuer risk. Credit ratings try to estimate the
relative credit risk of a bond based on the company’s ability to pay. Credit rating agencies
periodically review their bond ratings and may revise them if conditions or expectations
change. The corporate bond contract (called an indenture) often includes terms called
covenants designed to limit credit risk. For instance, the terms may limit the amount of debt
the company can take on, or may require it to maintain certain financial ratios. Violating
the terms of a bond may constitute a default. The bond trustee monitors the company’s
compliance with the terms of its indenture. The trustee acts on behalf of the bondholders
and pursues remedies if the bond covenants are violated.

Interest Rate risk

The value of the bond is affected by interest rate changes. When interest rates rise, bond
prices fall and vice versa. The longer the bond’s maturity, the more time there is for rates to
change and, as a result, affect the price of the bond. Therefore, bonds with longer maturities
generally present greater interest rate risk than bonds of similar credit quality that have
shorter maturities. To compensate investors for this interest rate risk, long-term bonds
generally offer higher interest rates than short-term bonds of the same credit quality. For
example, imagine one bond that has a coupon rate of 2% while another bond has a coupon
rate of 4%. All other features of the two bonds—when they mature, their level of credit
risk, and so on—are the same. If market interest rates rise, then the price of the bond with
the 2% coupon rate will fall by a greater percentage than that of the bond with the 4%
coupon rate. This makes it particularly important for investors to consider interest rate risk

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when they purchase bonds in a low-interest rate environment. We can summarize the
observations about interest rate change in the following propositions:

 Bond prices and yields are inversely related: As yields increase, bond prices fall; as
yields fall, bond prices rise.
 An increase in a bond’s yield to maturity results in a smaller price change than a
decrease in yield of equal magnitude.
 Prices of long-term bonds tend to be more sensitive to interest rate changes than
prices of short-term bonds.
 The sensitivity of bond prices to changes in yields increases at a decreasing rate as
maturity increases. In other words, interest rate risk is less than proportional to bond
maturity.
 Interest rate risk is inversely related to the bond’s coupon rate. Prices of low-coupon
bonds are more sensitive to changes in interest rates than prices of high-coupon bonds.
 The sensitivity of a bond’s price to a change in its yield is inversely related to the yield
to maturity at which the bond currently is selling.

Market Risk

The value of the bond is also subject to demand and supply forces. Should the bond market
as a whole decline, the value of individual bonds may be brought down by market
sentiments regardless of their fundamental characteristics. As such, this market risk is
relevant if the investor decides to sell the bond and not hold it to maturity.

Inflation risk

Inflation is a general rise in the prices of goods and services, which causes a decline in
purchasing power. With inflation over time, the amount of money received on the bond’s
interest and principal payments will purchase fewer goods and services than before.

Liquidity Risk

When there is a lack of buyers or sellers in the market, the investor may not be able to
execute the trade or may be forced to trade at a value significantly away from the investor’s
desired price. This is liquidity risk. Liquidity is the ability to sell an asset, such as a bond,
for cash when the owner chooses. Bonds that are traded frequently and at high volumes
may have stronger liquidity than bonds that trade less frequently. Liquidity risk is the risk
that investors seeking to sell their bonds may not receive a price that reflects the true value
of the bonds (based on the bond’s interest rate and credit- worthiness of the company). If
you own a bond that is not traded on an exchange, you may have to go to a broker when
you want to sell it. In addition, the bond market does not have the same pricing

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transparency as the equity market, as the dissemination of pricing information is more
limited for corporate bonds in comparison to equity securities such as common stock.

Foreign exchange risk

The investor is exposed to fluctuations in foreign exchange rate when the investor trades in
bonds that are denominated in a foreign currency. Foreign currency exchange rate may
move adversely and may erode the returns on the bond investment.

Counterparty risk

There are counterparty risks for bonds which are traded over-the-counter (OTC).
Counterparty risk is present when the party who goes into a trade or transaction does not
fulfill its obligations. For this reason, OTC transactions may involve increased risks.

Call risk

Some bonds may have a “call provision” which give their issuers the option to redeem the
bonds at a specified price prior to maturity. Declining interest rates may accelerate the
redemption of a callable bond, where the investor’s principal will be returned earlier than
expected. When this happens, the investor may have to reinvest the principal at a lower
interest rate (or coupon rate).Investors are advised to consider all risks by reading the
prospectus /information memorandum / term sheet or obtaining advice from a qualified
financial adviser representative before they make a commitment to purchase any bonds.

4.5 Rating of bonds

If you invest in bonds, notes, or other debt instruments, you have probably come across
credit ratings. These credit ratings usually appear in the form of alphabetical letter grades
(for example, ‘AAA’ and ‘BBB’) and are intended to give you an estimation of the relative
level of credit risk of a bond or a company or government as a whole.

Credit ratings can be a useful item of information to consider when evaluating an

investment along with other information. But if you use credit ratings, you should
understand their limitations. You should not base your investment decision solely on a
credit rating or treat a credit rating as if it were investment advice.

A bond rating is a grade given to bonds that indicates their credit quality. Private
independent rating services such as Standard & Poor's, Moody's and Fitch provide these
evaluations of a bond issuer's financial strength, or it’s the ability to pay a bond's principal
and interest in a timely fashion. A credit rating is an assessment of an entity’s ability to pay
its financial obligations. The ability to pay financial obligations is referred to as
“creditworthiness.” Credit ratings apply to debt securities like bonds, notes, and other debt

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instruments (such as certain asset-backed securities) and do not apply to equity securities
like common stock. Credit ratings also are assigned to companies and governments.

The entity whose creditworthiness is being assessed typically is referred to as an obligor

or issuer. Obligors include entities such as corporations, financial institutions, insurance
companies, or municipalities that have been rated by a credit rating agency. Credit ratings
generally reflect a relative ranking of credit risk. For example, an obligor or debt security
with a high credit rating is assessed by the credit rating agency to have a lower likelihood
of default than an issuer or debt security with a lower credit rating. Credit rating scales,
symbols, and definitions may vary among credit rating agencies. Credit ratings typically are
expressed on a scale of alpha and/or numeric symbols, and these symbols are defined by
the particular credit rating agency issuing those ratings. A typical credit rating scale, as
shown in the table below, has a top rating of ‘AAA’ and may have a lowest rating of ‘D’
(indicating default). some credit rating agencies’ scales distinguish between investment
grade and non-investment grade (i.e., “speculative” or “high yield”) ratings and they draw
this distinction between the ‘BBB’ and ‘BB’ rating categories (in other words, a rating that is
‘BBB-minus’ or higher is investment grade and a rating that is lower than ‘BBB-minus’ is
non-investment grade).

What a credit rating is not

A credit rating does not reflect other types of risk, such as market or liquidity risks, which
may also affect the value of a security. Nor does a credit rating consider the price at which
an investor purchased a security, or the price at which the security may be sold. You should
not interpret a credit rating as investment advice and should not view it as a
recommendation to buy, sell, or hold securities. A credit rating is not a guarantee that a
financial obligation will be repaid. For example, an ‘AAA’ credit rating on a debt instrument
does not mean the investor will always be paid with absolute certainty—instruments rated
at this level sometimes default.

Determinants of Bond Safety

Bond rating agencies base their quality ratings largely on an analysis of the level and trend
of some of the issuer’s financial ratios. The key ratios used to evaluate safety are:

 Coverage ratios. Ratios of company earnings to fixed costs. For example, the times
interest- earned ratio is the ratio of earnings before interest payments and taxes to
interest obligations. The fixed-charge coverage ratio includes lease payments and
sinking fund payments with interest obligations to arrive at the ratio of earnings to
all fixed cash obligations. Low or falling coverage ratios signal possible cash flow
difficulties.

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  Leverage ratio. Debt-to-equity ratio. A too-high leverage ratio indicates excessive
indebtedness, signaling the possibility the firm will be unable to earn enough to
satisfy the obligations on its bonds.
 Liquidity ratios. The two common liquidity ratios are the current ratio (current
assets/current liabilities) and the quick ratio (current assets excluding
inventories/current liabilities). These ratios measure the firm’s ability to pay bills
coming due with its most liquid assets.
 Profitability ratios. Measures of rates of return on assets or equity. Profitability
ratios are indicators of a firm’s overall performance. The return on assets (earnings
before interest and taxes divided by total assets) or returns on equity (net
income/equity) are the most popular of these measures. Firms with higher return
on assets or equity should be better able to raise money in security markets because
they offer prospects for better returns on the firm’s investments.
 Cash flow-to-debt ratio. This is the ratio of total cash flow to outstanding debt.

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4.6 Analysis of convertible bonds
Convertible bonds Convertible bonds give bondholders an option to exchange each bond
for a specified number of shares of common stock of the firm. The conversion ratio gives the
number of shares for which each bond may be exchanged. Suppose a convertible bond is
issued at par value of $1,000 and is convertible into 40 shares of a firm’s stock. The current
stock price is $20 per share, so the option to convert is not profitable now. Should the stock
price later rise to $30, however, each bond may be converted profitably into $1,200worth
of stock. The market conversion value is the current value of the shares for which the bonds
may be exchanged. At the $20 stock price, for example, the bond’s conversion value is$800.
The conversion premium is the excess of the bond price over its conversion value. If the
bond were selling currently for $950, its premium would be $[Link] bondholders
benefit from price appreciation of the company’s stock. Not surprisingly, this benefit comes
at a price; convertible bonds offer lower coupon rates and stated or promised yields to
maturity than nonconvertible bonds. At the same time, the actual return on the convertible
bond may exceed the stated yield to maturity if the option to convert becomes profitable.

An example of a simple convertible bond

On Sep 2013, Primus Telecom issued the following convertible bond.

Size: US$ 110 million

Term: 7 years

Redemption date: 15 Sep 2020

Nominal value: US$ 1000

Interest coupon: 3.75%

Conversion price: US$ 9.3234

Conversion ratio: 107.257

Market price at issue: 100

The bond has a nominal (or par) value of $1000. The market price is always quoted as
percentage of the nominal value, which means you have to pay $1000 to buy this bond at
issue. Like a straight bond, it pays you coupon semi-annually, so each coupon payment will
be 1000*3.75%/2 =$18.75. In addition, it allows you to exchange the bond for 107.2570
shares any time before maturity, which is 09/15/20. If the bond is not converted, it will be

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redeemed at par on maturity. Finally, the conversion price is equal to the nominal value
divided by conversion rate.

Many of the convertible bonds are also callable by the issuer on a set of pre-specified dates,
which may lead to “forced conversion”. Consider a callable convertible bond where the
issuer has the option to call the bond at par tomorrow. However, the conversion value of
the bond is $110. In this case, the investor would be forced to convert the bond into shares
worth $110 before the call date. The call feature is an option with the issuer, and it will
decrease the value of the convertible bond.

To make things more complicated, there are “protected” calls or “soft” calls where the bond
can be called only if the share price (or the average share price over the past 20days) is
above a certain barrier.

Some convertible bonds may also have put features that allow the buyer to put back the
bonds to the issuer. This is buyer’s option and it would increase the value of the convertible
bond. If the call and put features occur simultaneously, priority is given according to the
prospectus.

In the early 1990s, Japanese corporations began to issue CBs with “refix Clauses”. In its
simplest form, it changes the conversion ratio subject to the share price level on certain
days between issue and expiry. Suppose on one of these days the share price drops by20%,
then the refix clause may increase the conversion ratio by 20%. This feature makes it
attractive to investor and will increase the value of the convertible bond.

There are complications on conversion proceeds. First, some bonds can be converted into a
combination of shares and cash. In most cases, the conversion number as well as the cash
amount varies as a function of time. Second, when a buyer converts and receives shares,
these shares may either be distributed from existing stock or new shares just issued. In the
latter case, there is a dilution effect the same company issues more shares. Third, shares
receive upon conversion may be denominated into a different currency. For example, the
underlying shares of US dollar convertible bonds may be traded in Japanese yen. Buyers of
this type of convertible bonds are also exposed to currency risk.

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